What it means
In its plain sense, value deflation means that an asset, product or balance has become worth less than before. A shop unit whose rental value drops, or a stockpile of electronics that becomes outdated, has suffered value deflation.
The cause can be weak demand, new technology or simple wear and tear. The second use is a technique.
To compare a company's sales over ten years, an analyst divides each year's dollar figure by a price index, which tracks the general level of prices, to strip out the effect of rising or falling prices. The result is called a real figure, as opposed to the nominal figure on the page.
A business whose sales grew by 20% in dollars may have grown by much less, or even shrunk, once price changes are removed. Value deflation should not be confused with general deflation, which is a broad fall in the price level across an economy.
Deflation of that sort can raise the real burden of debts, because each dollar owed becomes harder to earn, which is a reason lenders and borrowers both watch it closely. For decision makers the point is to compare like with like.
Contracts, budgets and targets set in nominal dollars should be reviewed in real terms whenever price levels move noticeably. Long-term supply contracts with fixed prices are a common place where the effect bites.
In practice
Real-world examples.
Example
A landlord's office building was valued at $5 million before a local employer closed. A fresh valuation puts it at $4.2 million. The $800,000 fall is value deflation caused by weaker demand. The landlord has to decide whether to hold the property and wait for recovery or to sell at the lower figure.
Example
A manufacturing group reports sales growth of 15% over three years. The finance team applies a price index that rose by 18% over the same period. In real terms sales shrank by about 2.5%, which changes the story for investors. The team decides to show both nominal and real figures in the annual report.
Example
A retailer holds a stock of last season's smartphones bought for $400,000. A new model launch means they can only be sold for $250,000, a drop of $150,000 or 37.5%. The retailer records a write-down, which reflects the value deflation of the old stock.
Formula
Calculation
Real value = Nominal value / Price index x 100
A business has revenue of $1,000,000 in a base year where the price index is 100. Several years later its revenue is $1,200,000 and the price index has risen to 125. Real value = 1,200,000 / 125 x 100 = 9,600 x 100 = $960,000 in base-year prices. Compared with $1,000,000, real revenue has fallen by 40,000 / 1,000,000 = 4%, even though nominal revenue grew by 20%.Case study
Seen in the real world.
This illustrative case concerns a fictional business, Pendleton Marine Supplies, whose management proudly presented a ten-year sales chart rising from $2 million to $3 million. The chart suggested steady progress and the board agreed to a new round of bonuses.
A new finance manager deflated the series using a price index that had risen by 60% over the decade. In base-year prices, sales had moved from $2 million to $1.875 million, meaning the business had actually shrunk in real terms by about 6%.
The board did not cancel the bonuses, but it changed the targets to real growth and began a review of pricing, which had lagged behind the cost of boat parts. This fictional example shows how nominal growth can hide value deflation, and why long-run comparisons should always be adjusted before conclusions are drawn.
Watch out
Common mistakes.
- Comparing nominal dollar figures across many years. Rising prices make older figures look smaller and newer figures look larger than the real change.
- Using the wrong price index. A general consumer index may not match the prices a particular business faces, so choose an index that fits.
- Confusing value deflation with economy-wide deflation. One describes a fall in the worth of a specific item, the other describes a general fall in prices.
Questions
People also ask.
How do I convert a past figure into today's prices?
Multiply it by today's index and divide by the index for the earlier year, so a $100 item from a year with an index of 80 becomes 100 x 100 / 80 = $125 in prices where the index is 100.
Does a fall in market price always mean value deflation?
A fall in price is a fall in market value, but the intrinsic value may not have changed, so a drop is not always a permanent loss of worth.
Why do accountants write down inventory?
When stock can only be sold for less than it cost, the accounts must show the lower amount so profit is not overstated and readers are not misled about what the stock is worth.
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